We are frequently asked by commercial lenders to explain the difference between lines of credit that are made on a demand basis versus those that are so-called “committed” lines of credit (i.e., lines of credit that have maturity dates – customarily one, two, or three year expirations). In short, demand lines give greater flexibility to a lender and typically impose fewer reporting and covenant requirements on a borrower. By contrast, committed lines provide a borrower with greater certainty as to availability of funds over a specified period, but usually require a borrower’s compliance with certain financial covenants which necessarily involves more detailed financial reporting by a borrower to a lender.
Lenders often prefer to provide borrowers with demand lines of credit as opposed to committed lines. Demand lines (properly managed by a lender) give a lender greater flexibility in the event a borrower experiences a deteriorating financial situation. Courts in Massachusetts have made clear that the holder of a demand note has complete discretion on when, why, and if to demand repayment of the note. The unfettered right to make demand may give a lender leverage to insist on changes in the terms of loan documents or require additional collateral as a condition of not proceeding with acceleration and demand. Of course, as in most circumstances, lenders should be judicious in making unreasonable or rash demands as a matter of sound banking policy. Demand lines also require less work for a lender as they are often documented without restrictive financial covenants, which require regular monitoring by the lender. Similarly, borrowers often prefer demand facilities if it eases their reporting burdens to a lender.
On the other hand, sometimes borrowers prefer committed lines of credit since the financial covenants imposed by such facilities provide a borrower with clearer guidelines in regard to their expected financial performance. A lender’s ability to accelerate a loan or request modifications under a committed facility is also more likely to be affected by the lender’s course of conduct in dealing with a borrower. If a lender has ignored a borrower’s failure to provide mandated reporting on a timely basis or a borrower’s declining financial performance for a period of time and then attempts to declare a default and/or demand repayment without any warning to a borrower, a court may determine that the lender is not acting in a commercially reasonable manner or in good faith. While it is incumbent upon a lender to act in a commercially reasonable manner and acting in good faith is always a sound business guideline, whether a loan is a demand or a committed facility, it has been our experience that this standard is more likely to be imposed upon lenders (thus with potential benefits to a borrower) where the loan in question is a committed line of credit.
Borrowers often tend to request committed lines of credit from lenders in multi-facility loan arrangements. Borrowers can be hesitant to agree to a demand line of credit structure when they also have other term loan arrangements with lenders due to the customary cross-default and frequent cross-termination provisions in a lender’s loan documents. More sophisticated borrowers are not deterred by the reporting requirements accompanying committed lines of credit since such borrowers are often preparing such reports for their own internal purposes anyway.
We are often asked whether it is possible for a demand line of credit to have financial covenants. While the answer is “yes, there is no prohibition on a demand line having financial covenants,” we have found that it would be unusual for a borrower to agree to such a loan arrangement since it would deprive a borrower of the expected benefits of a demand line for a borrower, namely the reduced burden of having to comply with financial covenants. A demand line with financial covenants is certainly advantageous for a lender who wants to monitor a borrower’s performance more closely but has fewer benefits for a borrower. In such a dual structure, the line is typically due on demand and with notice absent a specific default and without demand or notice if premised on an actual default.
We have seen many lenders over the years include expiration or renewal dates in demand lines of credit. They often include language that says a loan facility is due “upon the earlier of DEMAND or the Expiration Date.” We do not consider combining a demand obligation with an expiration date in this manner as a “best practice.” Referencing an expiration or renewal date in connection with a demand facility could potentially impact the demand nature of the loan. A judge may interpret this language as the lender not truly intending to give a borrower a demand loan. Thus, a court may treat it like a committed facility, thereby preventing a lender from relying upon the demand language in the note to demand repayment at any time as the lender originally intended. This type of renewal language can also increase the legal fees for a borrower since the renewal or expiration date needs to then be amended annually and will often involve legal fees incurred by outside counsel for the lender, payable by the borrower. Allowing a line of credit which previously was automatically and repeatedly renewed to simply expire, without prior notice to the borrower, is also fertile ground for lender liability claims.
There are numerous considerations for whether a lender should provide a demand versus a committed line of credit to a borrower. A borrower will also have different factors to consider in determining what type of facility will best suit its own needs. Additionally, the state of the economic market (which can often be industry dependent) will have an impact on each party’s transactional leverage, whether a particular borrower is much sought after by other commercial lenders or whether lenders are in a stronger position to dictate the terms of such facilities. Leverage may ultimately be the determining factor in the choice of a demand versus committed line of credit.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.